When deciding to prepay your fixed-rate CMBS debt, whether through yield maintenance or defeasance, most borrowers have questions. Chatham routinely supports the majority of principal balance, including the largest individual loans, defeased in a given year. View Chatham's list of yield maintenance and defeasance FAQs.
- How does defeasance work?
- What is Chatham's role in a defeasance?
- What is residual value and where does it come from?
- What is the overall defeasance timeline?
- How accurate is my estimate?
- How does defeasance compare with yield maintenance?
- How are the defeasance bonds purchased?
- Do I need to purchase defeasance bonds to make all my remaining loan payments through maturity, or just the payments up to the early open prepayment date?
- Who are the additional parties involved in a defeasance and what do they do?
- Who sets the transaction fees for these parties?
- How can I make debt extinguishment easier and less costly in the future?
How does defeasance work?
Defeasance is the process through which a borrower is released from the financial obligations of its debt. The borrower purchases a portfolio of government bonds as replacement collateral to secure the debt and to generate the cash flows required to meet the scheduled payments of principal and interest remaining on the loan.
The defeasance bonds are transferred to a newly created special-purpose entity called a successor borrower, who assumes the debt obligations from the original borrower. A securities intermediary holds the bonds in a restricted account and sends the income from the bonds to the loan servicer to meet the debt obligations. An independent accountant reviews the transaction and certifies that the bond portfolio is sufficient to satisfy the debt.
The defeasance process is coordinated by the defeasance consultant and takes 30-45 days. The borrower begins the process by submitting a notice of intent and defeasance deposit to the loan servicer. The loan servicer will prepare legal documents for the borrower to review and execute, and will also request due diligence documents from the borrower. Once the documents are finalized, the defeasance can close.
The closing takes place in escrow over two to three days, simultaneous with the underlying refinance or sale. On the first day of the closing process, the borrower locks in the price of the bonds and commits to purchasing them. The borrower funds escrow the day before the final closing date, typically using proceeds from the refinance or sale. On the final closing date, the bonds are delivered to the securities intermediary bank, and funds are disbursed from escrow to purchase the bonds.
What is Chatham's role in a defeasance?
As an independent, expert advisor, Chatham acts as the borrower’s defeasance consultant. Chatham provides cost estimates, advises the borrower on how to navigate the defeasance process, engages counterparties, and ensures that the defeasance is executed in a timely and cost-effective manner. If allowed by the loan documents, Chatham can also purchase the defeasance bonds and establish the successor borrower entity that will assume the loan at closing.
The role of defeasance consultant is unique because it is the only party with expert knowledge of the entire process that also acts as an advocate for the borrower. Chatham’s goal as defeasance consultant is to simplify the defeasance process so that our clients can focus on the underlying real estate transaction.
What is residual value in defeasance and where does it come from?
Residual value is cash in the defeasance account that is not pledged to make the loan payments. Residual value comes from two different sources: float value and prepayment value.
Float value accrues gradually over the remaining life of the defeased loan. It arises from small timing mismatches between the incoming cash receipts from the bonds and outgoing cash payments on the loan. Cash sits in the defeasance account for short periods of time, where it earns interest at money market rates. The float value is released to the successor borrower when the loan is repaid at maturity.
Prepayment value arises when provisions in the loan documents require the defeasance bonds to provide for all remaining loan payments through the loan’s maturity date, but still allow the loan to be paid off on the early open prepayment date. The successor borrower will pay off the principal balance of the defeased loan on the early open prepayment date. When the loan is paid off, the remaining bonds in the defeasance account are released to the successor borrower, who then immediately sells them on the market. The difference between the sale price of the released bonds and cost to pay off the defeased loan is the prepayment value.
Chatham was the first company to share residual value. Since the year 2000, we have returned $170 million+ in residual value to our clients. Chatham gives clients two options to receive this value: on a present-value basis at the defeasance transaction closing date or on an actual-value basis at loan maturity. As part of Chatham’s continuing commitment to transparency, we always disclose the total amount of residual value earned and the exact terms of our sharing arrangements.
What is the overall defeasance timeline?
We recommend allowing at least 40 days to complete the defeasance process. In most cases, the loan servicer will waive any stated notice period and will also waive any requirement that the defeasance close on a loan payment date. However, loan servicers may charge expediting fees for closing in less than 30 days from the date of notice and deposit.
Once the defeasance process has started, the closing date is flexible and can be changed until the defeasance bonds are purchased.
How accurate is my estimate and how often does it change?
The securities cost shown on your estimate is the current market price of the defeasance bonds. Bond prices change constantly, so estimates that are compiled even a few minutes apart may show different costs. Costs will very likely change between the time of the estimate and the time of the defeasance closing. The sensitivity, or DV01, indicates how much the securities cost will change for every basis point change in yield rates. If rates go up, the securities cost will go down, and vice versa. At closing, Chatham endeavors to purchase the lowest-cost portfolio of bonds by holding a competitive auction among multiple banks (when allowed by the loan documents).
The third-party fees shown on your estimate are set independently by the respective parties to the defeasance. Any estimate of these fees is based on fee schedules and past experience.
How does defeasance compare with yield maintenance?
Both yield maintenance and defeasance allow borrowers to unencumber the underlying real estate asset. However, from a legal and economic perspective, the two processes are fundamentally different. Yield maintenance is the actual prepayment of the loan, while defeasance entails a substitution of collateral and a legal assumption of the loan by the successor borrower.
A yield maintenance prepayment has two components: the unpaid principal balance of the loan and a prepayment penalty. The prepayment penalty typically is determined by calculating the present value of the remaining loan payments, with a discount rate equal to the current yield on the U.S. Treasury that matures closest to the loan’s maturity date. The only transaction fee is a small processing fee to the loan servicer.
In contrast, the cost of defeasance is determined by the price of a portfolio of bonds that are sufficient to provide for the remaining loan payments, plus transaction fees to several third parties.
How are the defeasance bonds purchased?
The cash required to purchase the defeasance bonds usually comes from the proceeds of a refinance or sale of the property.
If allowed by the loan documents, the borrower may purchase the bonds from any securities provider. Chatham has developed a highly effective auction process that guarantees our clients efficient pricing on the bond purchase. Chatham conducts the auction live, ensuring that all bids are highly competitive. Chatham is not a broker dealer, and does not receive incentives from banks. We don’t collect fees, premiums, or profits from the purchase of the bonds. Our only interest is getting the lowest price for our clients.
Do I need to purchase defeasance bonds to make all my remaining loan payments through maturity, or just the payments up to the early open prepayment date?
Some loans feature an early open prepayment window that allows the loan to be prepaid at par before the maturity date. The loan documents govern whether the defeasance bonds must provide for all remaining loan payments through the loan’s maturity date or just the payments up to the early open prepayment date.
When a prepayment window exists, Chatham will attempt to structure the defeasance bonds to the start of the prepayment window only. Doing so can create significant savings for the borrower.
Who are the additional parties involved in a defeasance and what do they do?
- Loan servicer: The loan servicer asks for notice of defeasance and an up-front deposit. They provide official copies of the loan documents and loan amortization schedule. Following defeasance, they continue to service the loan.
- Loan servicer’s counsel: The loan servicer engages a law firm as their representative for the defeasance. The loan servicer’s counsel drafts the defeasance documents, collects due diligence items, and approves certain aspects of the transaction on behalf of the loan servicer.
- Rating agencies: Rating agencies may review large defeasances to confirm the defeasance will not downgrade the securitization pool. Rating agency review may add as many as 10 business days to the defeasance process.
- Securities intermediary: The securities intermediary (also called a custodian) is a bank that holds the defeasance bonds in a restricted account and sends the cash receipts from the bonds to the loan servicer to make the remaining loan payments.
- Accountant: An independent CPA firm issues a report certifying that the cash receipts from the portfolio of defeasance bonds will be sufficient to provide for all remaining loan payments.
- Successor borrower: The successor borrower is a single-purpose, bankruptcy-remote LLC established to assume the financial liability of the loan from the borrower and retain ownership of the defeasance bonds.
- Successor borrower’s counsel: The successor borrower’s counsel files documents to incorporate the successor borrower entity and reviews the defeasance documents.
- Title company: The title company that handles the underlying refinance or sale also handles title and escrow for the defeasance.
- Borrower’s counsel: Most borrowers engage an attorney to review the defeasance documents and assist with returning due diligence items to the loan servicer.
Learn more about defeasance parties and process, as well as common pitfalls.
Who sets the transaction fees for these parties?
The parties involved in a defeasance set their fees independently. Any estimate of the transaction fees is based on past experience and standard fee schedules. Some parties will discount their fees if several loans in the same securitization are defeased at once.
How can I make debt extinguishment easier and less costly in the future?
Defeasance may be a requirement of the existing loan, but Chatham can advise clients to achieve more borrower-friendly defeasance and prepayment language on new debt.
Certain specific defeasance terms can be adjusted in the negotiation period before origination. Some of the most impactful are defeasance portfolio purchasing and successor borrower rights, as well as the structure and composition of the bond portfolio required.
Defeasance may even be avoided altogether by electing a yield maintenance prepayment penalty or even considering a floating-rate loan, for which Chatham offers strategies to manage interest rate risk.
Chatham Financial has executed over $148 billion total principal defeased, and returned over $187 million in residual value to borrowers. Defeasance consultants are a part of Chatham's global real estate financial risk management practice, solving common but complex capital markets challenges for commercial and multifamily real estate investors.
Need help with defeasance?
Contact a Chatham advisor about defeasance or yield maintenance.
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